Why Funds Can’t Buy Small Businesses?
Before answering this question, we need to first ask: “What is a small business?” Most investment banks, banks, and most retail investors consider a small business to have somewhere in the ballpark of $50m to $2bn in sales. Now, these numbers change some depending on exactly who you are talking with, but the bottom line is from our perspective a $50m to $2bn firm is massive.
When an M&A professional talks about business size, they usually use three categories: large cap ($10bn up), mid cap ($2 to $10bn), and small cap ($50m to $2bn). They are also often referring to just public companies.
These size categories dictate a lot of the norms in the space and have every type of buyer available to them
When we are talking about small businesses, we are generally referring to firms with less than $20m in sales. The world of buyers becomes a lot smaller.
To understand why smaller firms have fewer buyers let’s study a $100m private equity fund that buys small business. Funds have two mandates. The first mandate is to earn money (i.e. Return on Invested Capital) and deploy the funds under their management.
It is important to understand the second mandate: deploying funds. Funds want to avoid two problems: investing too much of their money in one target (too much risk without diversification that might impact their returns) and investing too little money in too many targets.
Why is it a problem to invest too little in too many targets? Most funds have similar financial structures. The individuals operating the fund (usually called general partners) are compensated with a 2% fee on the total assets under management ($100m in this hypothetical situation for an annual fee of $2m) and 20% carry (carry refers to the profit after returning the original money. If they earn $200m, then they return $100m and then get 20% of the remaining $100m).
The 2% fee is not just for pay the general partners salary it is also used to operate the fund. Here is the problem. Many of the costs to complete an acquisition don’t entirely depend on size. Therefore, a $20m acquisition does not cost significantly more than a $10m acquisition. There is a limit to how many transactions a fund can complete with their fixed 2% operational budget.
Based on our research (our sources are somewhat proprietary…sorry), the average fund closes 6 transactions a year with a staff of 13 people. Again, just like the cost, the man-hours for closing a $20m acquisition is similar to a $10m acquisition.
Based on Pepperdine’s 2014 Capital Market Survey, a business with $1m in EBITDA has an average equity check of $600,000. If a $100m fund were to target $1m EBITDA businesses, then they would need to buy 166 businesses.
Put another way they would have to buy 160 businesses more than the average fund. Most funds simply cannot target small businesses. Until the economics of funds significantly shift, this trend will not change.
What is the smallest business most funds will buy? With increased competition, funds are increasingly going to small businesses, but most funds can’t dip below $5m EBITDA threshold. Most businesses they acquire at the $5m EBITDA threshold are add-ons or businesses they are combining with another company.